Partner compensation.

by Mudrick, Howard L.

Abstract- Several different partnership compensation systems have been used by CPA firms. The more common compensation systems include a variety of democratic methods, including: equal distribution, lock-step, and seniority or longevity systems, where partners receive equal shares; buying and selling time, where partners are assigned inside and outside hourly rates; and the committee system, where compensation committees divide profits among partners. The criteria used for each system include: billable hours, billings, and collections. Firms may need to periodically change their compensation systems as the people or character of the firms change.

DEMOCRATIC SYSTEMS

The most common compensation systems are the democratic systems. One
of these is the equal distribution system, in which all partners receive
equal compensation regardless of their levels of effort or contribution
to the firm. For example, Partner A has 1,600 chargeable hours and a
good billing and collection record. Most of his work is done for long-
standing clients of the firm. Partner B has 1,100 chargeable hours; she
is a rainmaker and brings a good deal of work to the firm. Partner C
has, 1,100 chargeable hours and devotes several hundred hours to
practice management. Partner D has 1,300 chargeable hours and is the tax
expert for the firm. Each partner is contributing something different to
the firm, but all the contributions are meaningful.

Another common democratic system is the lock-step system. Groups of
partners (usually in the same age group or with like experience) receive
their initial compensation as partners and subsequent increases as a
group. In other words, all within that group receive the same increase
at the same time. For example, consider a firm that admitted two
partners in 1969, three in 1984, five in 1985, seven in 1986 and three
in 1988. The firm might have six groups, partners with the firm prior to
1984, and groups for 1984, 1986, and 1988. All of the partners within
the various groups would be compensated identically.

In the seniority or longevity system, distribution is based upon how
long the partner has been with the firm. For example, the longer a
person has been with the firm, the more he or she earns. Many lock-step
plans start phasing down particular groups at a certain age-for example,
age 60-while seniority systems usually continue to increase compensation
unrelated to the work being performed. The simple theory behind the
seniority system is that "you pay your dues" for many years and then
reap the rewards.

There are several advantages to the democratic systems. Internal
competitiveness is held to a minimum, and partners do not spend time
worrying or arguing over what they earn in relation to others of the
same age and experience. Competition is directed outwardly rather than
inwardly. Finally, the democratic systems promote the concept of the
firm as opposed to the individuals. It is interesting to note that firms
operating under democratic systems usually have good delegation and
specialization characteristics as well as a team approach to client
services.

However, for these systems to work, there are two important
requirements for success. The firm must experience continued and
unabated economic growth, and it must exercise great selectivity in
partnership admissions

BUYING AND SELLING TIME

Buying and selling time is another common method found in CPA firms
for dividing up compensation. Unlike the democratic systems, this method
promotes individualism instead of institutionalization. Each
professional is assigned an "inside" hourly rate and an outside" hourly
rate. Various methods are used for charging overhead usage. Firms that
are, in effect, space sharers might find this system useful.

When building a firm, however, this method has more disadvantages than
advantages. One of the concerns, for example, is that partners tend to
work only on what is profitable for them. Internal bargaining occurs
when work has to be done. Client service is secondary, as the
originating professional decides who will do the work, usually on the
basis of potential profit to her or him rather than who will do the best
job.

Buying and selling of time impedes departmentalization and
specialization, and creates internal strife. This method also fails to
recognize the time devoted to office governance and management with the
result that these areas often are inadequately managed. Finally, this
compensation approach often stifles the business developers in a firm;
over the long run, a firm will lose such valuable people.

COMMITTEE APPROACH

Compensation committees are frequently used to divide profits among
partners. Compensation committees sometimes have vague criteria and, in
a few cases, no set criteria at all. The committee typically examines
any objective data available and also considers some subjective factors
in arriving at its determination of distribution. The executive
committee of the firm often serves as the compensation committee. There
is no best way to compose compensation committees, and many different
systems are used.

The success of the committee usually depends on two major factors. It
must clearly enunciate the criteria to be considered prior to
distribution time, and it should make known whether particular factors
are weighed more heavily than others.

Partners who are dissatisfied with a compensation committee's
determinations typically complain that no one knows what the criteria
are, or, more commonly, that the criteria change without notice.
Partners want and are entitled to some say in compensation
determinations. The committee should seek input from all partners
regarding their own contribution and that of other partners. Many firms
use questionnaires to do this, though a few firms require the committee
to speak privately with each partner.

Benevolent Dictator

in younger firms, the managing-partner (or founding partner) often
sets the compensation for all partners alone. This is simply a variant
of the compensation committee approach. The managing partner tends to
work in a "benevolent dictator" style. Typically, this partner started
as a sole practitioner and built the firm him-or herself and tends to
dominate the firm so other partners are comfortable following his or her
lead.

POINT AND PERCENTAGE SYSTEMS

The point and percentage systems are an increasingly popular way to
determine individual partner compensation and assist in determining
income distribution. This is done under the theory that no one can argue
with "objective" standards and that determining income in an objective
manner is fairer," takes less time, and requires fewer individual
judgments.

The most common formulas credit partners with some percentage of fees
earned on matters they originate and the value of hours they bill. For
example, a partner originates 250,000 of work in 1989 for which he or
she is credited with 20%, or $50,000. In addition, 1,400 of the hours
worked were billed to clients at an hourly rate of $120 per hour, or
$168,000. The partner is credited with 80%, or $134,000. To the total of
these factors ($218,000), an overhead factor, of, for example 10%, is
applied. The adjusted amount of 196,200 is the basis on which the
partner's income is determined.

One Way of Doing It

One of the oldest point and percentage systems is the Hale and Dorr
System borrowed from the law firm of that name. In this formula a
committee looks primarily at the objective factors of hours worked,
origination and profitability, and then weighs them. The formula is
applied to monies collected. A weight of six is applied to the work done
(the workers' share), a weight of three for origination of the business,
and a weight of one for the profit (to the originator). Approved
management time and other work done for the firm is given the same
weight of six as for the work done. The figures spanning several years
are given consideration in order to arrive at a "fair" compensation for
the partners.

Bring the Business In

Business origination is a variant of the point and percentage system.
The partners are given credit on fees received, depending upon who
originated the work. Thus, the partner who can say, "This is my client,"
obtains the credit. Deciding who originated the work is not always an
easy matter.

Hours Billed or Hours Worked

A third point system used is the hours billed and/or hours worked
system. In this method, the partner gets credit for the number of hours
worked or for hours that have been billed. This would usually be from
50% to 80%.

A variation of this specifically awards points to the originator for
using other partners, staff and paraprofessionals. On the other hand,
some systems penalize the partner for using other partners, or, on the
other extreme, for doing the work him-or herself

Variations on the Theme

Point and percentage systems vary greatly. Some firms append an
additional credit to origination and hours. There might be a longevity
credit or an office management and administration credit. Often there is
some consideration for approved non-chargeable time, at partners'
regular hourly rates, or perhaps calculated at a lesser rate. An
increasing number of firms are using a composite of all of these point
and percentage systems.

Now for the Problems

There are several potential problems with these formula systems.
Foremost is that the formula systems do not properly measure the
contribution each professional makes to the firm. The formula systems
also foster "playing the numbers" and cause the partner to concentrate
more on his or her own compensation than on what is good for the client
or good for the firm. Also, seldom is the credit meaningful for
management time, training associates, team spirit and attitude.

Point and percentage systems usually cause hoarding of clients,
internal competition and under-utilization of partners. Most firms with
very objective formula systems act like associations of CPAs in which
each individual is more concerned with his or her clients and
compensation than in the overall success of the firm. in short, such
firms find themselves in the situation where "the tail is wagging the
dog. "

The fallacy with most formula systems is not so much in how they
actually divide profits, but rather in the effect they have on each
partner's attitude towards the firm as a whole. These systems tend to
de-emphasize leadership and may create a weak management structure. When
a firm faces problems with a weak or non-producing CPA, it is easy to
say, "Let the formula deal with it," rather than have the partners face
the issue head-on. The eventual result of such an attitude is a weak
firm with disgruntled partners.

By the Numbers

A serious fallacy is the belief by some that such a system is, indeed,
objective. In truth, it may turn out to be less objective than a so-
called "subjective system," because a formula system will invite
manipulation in order to have the numbers "come out right." Typical of
such manipulation would be the splitting of origination credits to
encourage another partner to assist the originating partner in handling
work.

In some situations, one partner max, have control over another by
refusing to delegate work and thus, through the "objective formula,"
create a situation in which a partner's "numbers" look bad, eventually
leading to a reduction in income. This is particularly true for those
who specialize within the firm and depend heavily upon referrals from
other partners.

Nor does the formula say to a partner, "The time you spend
supervising, billing and directing other partners and associates is as
valuable, whether billable or non-billable, as the time of a partner who
seldom uses or trains others and who works, bills and collects for as
many hours as are available." Obviously, today's economic realities
require as much leveraging of staff time as is feasible for the firm.
Thus, the point and percentage systems can defeat that purpose and, in
the long run, result in lower income for all partners.

"ROUGH JUSTICE" SYSTEMS

The final type of system is the total contribution or rough justice
system. This approach involves the use of a compensation committee (in a
small firm, this may be all of the partners), a set of criteria to be
considered, and in some firms a discretionary fund to be used in
particular circumstances. In this system, the compensation committee
works with a pre-defined set of criteria. This is not a contradiction of
earlier comments relating to formula systems. Records of the economics
of the practice and of the partners must be maintained and considered,
but total contribution (past, present and anticipated for the future)
cannot be computed by formula.

Many firms include the criteria in their partnership agreements, and
the criteria are often broad and simple. For example, the criteria might
include a review of the following: cooperation with other partners,
quality and quantity of the professional work, leadership ability,
dedication and efficiency, training and effective use of staff, ability
to satisfy and bring clients continually back to the firm, ability to
attract new clients, attitude and cooperation in dealing with problems,
and historical contributions.

Rough justice systems usually involve several tiers of compensation.
For simplicity's sake, three tiers will be discussed, although a firm
may have more or less depending upon the size of the partnership and the
particular needs of the firm.

Tiers One and Two

In tier one, each partner receives a fixed monthly draw representing
the first level of income distribution, The draw will apply against the
partner's participation in the profits as determined under tiers one and
two. The draws should not be considered as expenses in determining
profits and losses. Normally, firms should not set salaries exceeding
70% to 80% of each partner's prior year total compensation, excluding
pension and profit-sharing contributions.

Net profits or losses in tiers one and two will be shared among the
partners on the basis of units of participation. Annually (or less
often) each partner will be allocated a certain number of units
determined by the compensation committee. The committee will consider
the criteria outlined previously. It will not be necessary to adjust the
units of participation when a new partner is admitted; the new partner
is simply assigned a number of units. Units are easily translated to
percentages, but percentages require change when partners are admitted
or depart, except in unusual circumstances such as gradual retirement. A
partner's unit should not decrease. A firm might also consider a maximum
number of units for each partner, say 100. Each partner's share in the
firm's net profit or loss will be in direct proportion to the ratio of
his or her units to the total number of units of all partners. Should a
partner's draw and periodic distributions during the year exceed his or
her interest in the year's profits, he or she will be charged for the
deficiency during the next fiscal year.

The Third Tier

A third tier may be used for one of two purposes. Some firms will
budget for a fixed dollar amount of profit. Anything achieved beyond
this during the year may be split equally among all partners. An
alternative approach is to use the amounts in the third tier to reward
unusual performance, seniority, an extraordinary fee, or other
significant contribution. This tier tends to focus upon an unusual
occurrence in that one year, whereas the first two tiers look at a
broader contribution over two to five years; the exact number of years
varies from firm to firm.

In the rough justice approach to compensation, each partner receives a
fixed monthly draw. Additional distributions are typically made on a
quarterly basis usually for income tax purposes. All calculations are
against net income, with a hold-back reserve determined by the partners.
The compensation committee usually spends some time getting input from
each partner before setting points.

CRITERIA FOR SETTING COMPENSATION

The five types of compensation systems (democratic, buying and selling
of time, compensation committee approach, point and percentage, and
total contribution, or rough justice) are the most commonly found
methods for setting partner compensation. Each system requires the use
of criteria for measuring performance.

There are more than a dozen criteria, the most popular being based on
objective data. Objective data include several years' history of
billable hours, billings, collections, aged accounts receivable, aged
work-in-process, write-offs, realization rates, and non-billable hours
by approved categories. As noted earlier, the objective criteria should
not be the sole consideration, and in some cases, may not be prime
determinants. The heavier producers, obviously, will be compensated more
hand-somely.

Some criteria may appear to be objective, but, quite to the contrary,
are difficult to quantify. Client development, as an example, includes
client retention and development of existing clients. A partner must be
able and willing to accept and successfully discharge primary and
working responsibility for individual clients, including necessary
client contacts and supervision of junior partners, professional staff
and paraprofessionals. These attributes are not readily quantifiable.

Another example of criteria that may be difficult to measure, is
getting new business, whether from new clients or from existing clients.
This is critical for the firm's continued well-being and growth, This
trait is hard to measure objectively, since it may be impossible to know
exactly why a client actually comes to the firm. However, by being aware
of what partners are doing and by discussing new work, the firm can keep
informed of the true source of the new business.

Productivity Measurement

Another criterion is productivity, that is, hours worked and fees
billed and collected. Defining the productivity of a professional is
more complex than simply looking at computer-generated numbers.
Productivity is a product of income generated, the hours the partner
works, the efficiency with which the partner handles the work, the
number of matters the partner handles, and income generated through work
with other professionals in the firm. It includes the value" of the time
worked and delegated to others-the condition of the partner's accounts
receivable and work-in-process inventory; generating fees in excess of
standard time; ability, to work independently; and the extent to which
the partner utilizes firm resources. Of special significance is the
existence of the multiplier effect-whether the partner's efforts extend
to others by spreading business or supervising and guiding them. The
priority consideration is dollars generated, not hours posted.

Additionally, it is expected that each partner will be "on duty" and
attending to the business of the firm either through work on client
matters or pursuing appropriate non-billable activities, for at least an
agreed upon amount of time. The partner should be expected to be
accessible during normal office hours.

Firm Policies

Special emphasis should be placed on the team concept and demonstrated
willingness to abide by the policies of the firm, including requirements
to keep time accurately and to turn in time sheets promptly. It also
includes introducing clients to other partners, turning over client
management and other controls to others when appropriate, and
contributing to the equitable and efficient distribution of work
assignments and client contacts. Further, this includes specializing and
developing expertise in particular areas to complement other abilities
in the firm. The partner should also be willing to abide by policy
decisions of the firm and uniform procedures in billing and handling
matters.

Quality

Quality, in its broadest sense, incorporates efficiency, diligence,
timeliness in handling work-be it client work, firm management or
business development. Quality includes a knowledge of applicable laws
and accounting pronouncements; imagination, creativity and innovation;
ability to write clearly and persuasively; ability to analyze quickly
and accurately; good judgment; ability to plan and implement legal
strategies; oral communication skills; and the ability to handle the
unexpected. Some firms also include the ability to negotiate.

A partner must be willing to delegate work horizontally or vertically
to ensure that the work is done when it is promised to the
client.

Participating in Firm Management

Firm management involves assuming responsibility for the firm's long-
term success. This includes overall business management, practice
management, recruiting, and marketing. A partner with management
responsibilities must regard that work as equally as important as client
work. The firm should expect that advanced standing in the firm will
bring an increasing level of contribution to the firm's success and
growth through commitment and effective leadership.

Some firms consider personal relationships and teamwork as an
additional management criterion in setting compensation. This goes
beyond simply participating in and cooperating with the firm's
committees, client sharing and introduction. It includes promoting
harmony and good will among firm members.

Active participation in firm activities is frequently overlooked. This
includes attendance at firm social and professional meetings,
participation in management decisions and activities, and recruitment.

Other Criteria

Professional and Community Activities. Most firms, large and small,
have long recognized the need for professional and community activities
and include it as a compensation guideline. Contributions that enhance
the firm's image and prestige through the maintenance of good relations
with other CPAS, involvement in CPE programs, publishing, participating
in professional activities, and assuming leadership roles in
professional, civic and charitable organizations in the community
contribute significantly to client development.

Professional Development. Professional development and delegation of
work is also important. Time and effort spent working with younger
accountants will increase their professional skills. Sharing work and
delegating the work to others ensures benefits to both the client and
the firm. Partners who are generally the most profitable to the firm are
those who generate work or supervise the work of others-those who have
the multiplier effect. They are especially profitable to the firm when
the work is delegated to the lowest levels possible and supervised by
the signing partner or manager.

Original Work. A few firms factor in the generation of original
contributions. This may be an idea for a book, a program, a CPE course,
or a marketing program.

Seniority. The consistency of the CPA's value to the firm over the
years and his or her contribution to the firm's growth and success is a
criterion in setting compensation for most firms. Note that seniority is
not a factor of age alone, nor is it only the number of years a CPA has
been with the firm. Rather, it means the number of years the partner has
spent developing and maintaining clients and building and enhancing the
firm's reputation.

Not all firms include all of these criteria. Nor do all firms weigh
these criteria in the same manner or ratios. Compensation criteria
evolve over time.

EVOLUTION OF COMPENSATION SYSTEMS AND CRITERIA

People and firms do not stay static; as people change or the character
of the firm changes, the compensation system and criteria must change.
Changes in economic conditions can impact the effectiveness of a system.
For example, obtaining audit engagements has become far more
competitive, and, in some cases, bidding wars have taken their toll on
profit margins. The fee pressures have caused firms to look at their mix
of work, seek cross-selling opportunities, and use the compensation
system to focus activities of their partners on practice opportunities.
Rapid growth, another aspect of the dynamic environment, will often
dissipate the camaraderie that the founding partners enjoyed.

This is not meant to encourage constant change and meddling with the
compensation system. In fact, compensation systems and criteria should
occur no more frequently than every three years.

Bonus Pools

Some firms utilize bonus pools and "adjustment pools" to provide a
dynamic element without changing the compensation system or criteria.
Bonus pools are typically the top criteria in a point and percentage
system. Similar arrangements can be added to the other systems.
Adjustment pools, used in prospective systems, are typically far smaller
than bonus pools and simply allow for a slight year-end adjustment when
a partner has exceeded expectations.

Firms also evolve through several stages. very small practices have a
tendency to keep things simple and egalitarian. Medium-sized firms and
those firms in a fast growth mode tend to emphasize criteria and
compensation systems that promote growth. Large firms in the top tiers
have the problem that management cannot know every partner personally.
Therefore, their compensation systems rely more on objective data and
tend to emphasize institutionalization of clients.

Prospective or Retrospective

An increasing number of medium-sized and large firms are moving from a
retrospective system to a prospective system. A retrospective system
divides up profits after the fact, that is, at year end. A prospective
system will set units or points or, in some cases, dollar amounts, at
the beginning of the year. If it is fixed, each partner can readily
calculate his or her percentage of the total profit and, therefore, will
tend to focus his or her attention upon increasing the total pie rather
than changing the size of the individual slices.

Compensation systems and criteria tend to change over time because
there is no single "correct" system. No one system will fit all firms or
satisfy the needs of any single firm throughout its evolution.
Therefore, partners should examine closely the criteria they wish to
promote and emphasize those characteristics in their compensation
systems. it may be helpful to get an objective outside opinion before
changing the firm's compensation system, or at least to assign several
partners to attempt to look at it objectively.

The cross-reference chart included with this article helps to put all
these factors and compensation systems in perspective. The chart should
assist in determining whether a compensation system for a firm is the
most effective and efficient given the character or culture of the firm.
The most effective compensation system and criteria for a firm is the
model that most closely fits a particular firm's present culture, goals,
and aspirations of the partners.

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